I am a long term buy and hold investor who focuses on dividend growth stocks

Tuesday, January 29, 2008

An alternative strategy to covered calls

Instead of selling covered calls, I actually am considering selling put options on stocks for some extra income, which could work in some situations. First, when you are selling a naked put you are obligated to buy the stock from the put buyer, who has the right, but not the obligation to sell it to you at a predetermined strike price. If you invest a certain amount of funds each month into stocks for example, you are basically always buying at the market price. If you always invest 120-125 dollars per month in DIA you are trying to buy one share per month at a time, rather than all 12 at once, by using the power of dollar cost averaging. In this situation, if you sell a naked put on DIA at an in the money strike of say 122, you would be paid $3.10 for the obligation to buy DIA at $122. If DIA does fall below 122 at expiration, you most probably would have to buy it at the strike price. With this strategy you bring your cost basis significantly below the current market price of 122.19 to an actual $118.90 if your option is exercised. Since stocks have historically always been in a bull market over the past 200 years, it makes sense to me to buy stocks that have shown some weakness, get dividend payments and live the good life.

The shortfall in this strategy is that you are only buying stocks which are showing weakness. In a strong market you will miss on potential gains, because you are only buying a stock that has fallen below your strike price and thus there’s no guarantee that that you will receive the lower cost basis. In weak markets you will be able to buy your stock at a lower price, but you will see your stock dive further down. Thus you might have been better off postponing your buy.

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